CEO Involvement in Selecting Board Members, Audit Committee Effectiveness, and Restatements*

Abstract

Research finds that independent audit committees and audit committee financial experts are generally effective in monitoring the financial reporting and auditing processes. However, not all audit committees that appear in form to be independent are in fact actually independent, and not all financial experts with similar backgrounds and credentials are equally effective. We examine whether the benefits of having an independent and expert audit committee are diminished when the chief executive officer (CEO) is involved in the selection of board members. Using restatements, our results provide some evidence that the monitoring benefits of having an independent and expert audit committee are only maintained when the CEO is not formally involved in selecting board members. Further, we find that these results appear to be driven by the more severe restatements, including misstatements in conjunction with fraudulent financial reporting. In addition, we find our results continue to apply in the post-SOX period – a period that provides data for a more exact measure of CEO involvement in the director selection process, although these data have more limited variation in audit committee characteristics. Finally, we find that the stock market’s negative reaction to a restatement announcement is mitigated only when the audit committee is independent and the CEO was not involved in selecting board members.